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Why Lifeline Bankruptcy Could Squeeze In Through the Back Door

Mike Konczal writes about lifeline bankruptcy reform, the easiest and most efficient way to solve the crisis in the housing market:

We could easily pass a streamlined, modified version of bankruptcy just for this crisis. Adam Levitin has proposed this with his Chapter M for Mortgage bankruptcy. It would remove foreclosure actions from state court to federal bankruptcy court. Successful petitions can be offered a standardized pre-packaged bankruptcy plan. The plan would be based on HAMP modification guidelines (interest rate reduction to achieve 31% DTI goal, but without federal funding) plus cramdown to address negative equity.

We can make this fair on the backend. If the homeowner redefaults we can speed up the foreclosure process. It wouldn’t affect non-mortgage lenders. It is fast-tracked relative to traditional Chapter 13. It can have clawback mechanisms to address potential future appreciation.

And going through the process can give the lender clean title. Because there’s this whole issue of who owns what in the securitization chain which is a few court cases away from putting our financial system over a cliff. And the best feature is that it has no cost to the federal government. Like other smart policy, it builds off already existing infrastructure, so it can be started immediately using existing courts and Chapter 7 panel trustees for sales.

Mike then explains all the reasons why this hasn’t happened, and probably won’t happen. The Tea Party was actually built on resistance to “subsidizing homeowners.” You don’t even have unanimity among the Democratic Party for this solution, to say nothing of near-universal opposition from Republicans.

And I’m not going to pretend that it will happen. Sen. Merkley may have offered lifeline bankruptcy reform in his basket of housing proposals, but the value of that comes only in restarting a national conversation about how to fix this crisis, not in the specifics. But there’s an outside chance that this will happen on its own, with the participation of the banks, consumer advocates and regular judges, not bankruptcy courts.

You can see that we are moving to a point of crisis. Judges continue to halt thousands of foreclosures, and while the banks continue to fight this, as it spreads from state to state they may not be in the position to effectively resist. In an important ruling in California, a judge found that the banks are legally bound to pursue a modification on a loan:

A bank is legally bound by its promise to try to work out a loan modification with a homeowner to avoid foreclosure, a state appeals court has ruled.

Thursday’s decision by the Second District Court of Appeal in Los Angeles involved a homeowner who said she refrained from protecting her home in a Bankruptcy Court filing after the bank promised to negotiate new loan terms – then foreclosed and evicted her.

The court refused to undo the foreclosure but said the owner, Claudia Aceves, could sue the bank for fraud. Her lawyer, Nick Alden, said the ruling should also help financially distressed homeowners who make several months of reduced payments in reliance on a bank’s promise to modify their mortgages.

“The homeowner has no choice but to work with the bank,” Alden said. Typically in such cases, he said, the lender will reject the final payment as insufficient, declare the borrower unqualified for a loan, and foreclose.

This could stop some banks from being able to foreclose in the future without proving that they sought modification first.

Finally, you have the chain of title cases, like the Ibanez ruling in Massachusetts, with others working their way through the courts across the country. You have Countrywide v. Kemp, where Countrywide admitted they didn’t convey the mortgages to the trusts. You have all the repurchase cases, some of which are picking up on these cases about chain of title, arguing that the bank must take back the mortgage-backed securities because they’re not legally backed by anything.

Here’s how the scenario would play out. After a wave of unfavorable court rulings, the banks would need a bailout to pay the claims. (Credit agencies are already writing the prospect of future bailouts into their ratings on major banks, expecting this to happen). It’s not that Congress would demand conditions written into this bailout, it’s that in the midst of this process, those invalid MBS would turn millions of mortgages into unsecured debt. At that point, judges could on behalf of the investors, as a make-good for their claims, rewrite the terms of mortgages for the homeowner, creating an “equitable mortgage.” They would have substantial leeway to make this modification.

Judges personally modifying every mortgage in existence would bring the legal system in America to a halt. But it would only take a few for a pattern to emerge. The point of lifeline bankruptcy is not that every homeowner would move into bankruptcy and get a judge to modify their loans, it’s that the threat of it would force banks to do the modifications on their own. In this case, a judge would need to basically bless the process and make the equitable mortgage legal, but I can see how that could be a relatively painless process.

Because lifeline bankruptcy is clearly the most sensible and proper solution to the mortgage crisis, and because progressives need to start a tradition of carrying forward the best ideas even if there’s no hope of immediate passage, Konczal and others should keep talking about them. But they also should recognize that this could be possible in a bank-door way.

UPDATE: Incidentally, the Senate Judiciary Committee will hold a hearing on bankruptcy courts and foreclosures tomorrow. Good for them.

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David Dayen

David Dayen

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